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The infinite-horizon investment–consumption problem for Epstein–Zin stochastic differential utility. II: Existence, uniqueness and verification for ϑ ∈ ( 0 , 1 ) $\vartheta \in (0,1)$

Author

Listed:
  • Martin Herdegen

    (University of Warwick)

  • David Hobson

    (University of Warwick)

  • Joseph Jerome

    (University of Liverpool)

Abstract

In this article, we consider the optimal investment–consumption problem for an agent with preferences governed by Epstein–Zin (EZ) stochastic differential utility (SDU) over an infinite horizon. In a companion paper Herdegen et al. (Finance Stoch. 27:127–158, 2023), we argued that it is best to work with an aggregator in discounted form and that the coefficients R $R$ of relative risk aversion and S $S$ of elasticity of intertemporal complementarity (the reciprocal of the coefficient of elasticity of intertemporal substitution) must lie on the same side of unity for the problem to be well founded. This can be equivalently expressed as ϑ : = 1 − R 1 − S > 0 $\vartheta := \frac{1-R}{1-S} >0$ . In this paper, we focus on the case ϑ ∈ ( 0 , 1 ) $\vartheta \in (0,1)$ . The paper has three main contributions: first, to prove existence of infinite-horizon EZ SDU for a wide class of consumption streams and then (by generalising the definition of SDU) to extend this existence result to any consumption stream; second, to prove uniqueness of infinite-horizon EZ SDU for all consumption streams; and third, to verify the optimality of an explicit candidate solution to the investment–consumption problem in the setting of a Black–Scholes–Merton financial market.

Suggested Citation

  • Martin Herdegen & David Hobson & Joseph Jerome, 2023. "The infinite-horizon investment–consumption problem for Epstein–Zin stochastic differential utility. II: Existence, uniqueness and verification for ϑ ∈ ( 0 , 1 ) $\vartheta \in (0,1)$," Finance and Stochastics, Springer, vol. 27(1), pages 159-188, January.
  • Handle: RePEc:spr:finsto:v:27:y:2023:i:1:d:10.1007_s00780-022-00496-5
    DOI: 10.1007/s00780-022-00496-5
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    References listed on IDEAS

    as
    1. Martin Herdegen & David Hobson & Joseph Jerome, 2023. "The infinite-horizon investment–consumption problem for Epstein–Zin stochastic differential utility. I: Foundations," Finance and Stochastics, Springer, vol. 27(1), pages 127-158, January.
    2. Martin Herdegen & David Hobson & Joseph Jerome, 2020. "An elementary approach to the Merton problem," Papers 2006.05260, arXiv.org, revised Mar 2021.
    3. Yaroslav Melnyk & Johannes Muhle‐Karbe & Frank Thomas Seifried, 2020. "Lifetime investment and consumption with recursive preferences and small transaction costs," Mathematical Finance, Wiley Blackwell, vol. 30(3), pages 1135-1167, July.
    4. Martin Herdegen & David Hobson & Joseph Jerome, 2021. "Proper solutions for Epstein-Zin Stochastic Differential Utility," Papers 2112.06708, arXiv.org.
    5. Anis Matoussi & Hao Xing, 2018. "Convex duality for Epstein–Zin stochastic differential utility," Mathematical Finance, Wiley Blackwell, vol. 28(4), pages 991-1019, October.
    6. Holger Kraft & Thomas Seiferling & Frank Thomas Seifried, 2017. "Optimal consumption and investment with Epstein–Zin recursive utility," Finance and Stochastics, Springer, vol. 21(1), pages 187-226, January.
    7. Martin Herdegen & David Hobson & Joseph Jerome, 2021. "An elementary approach to the Merton problem," Mathematical Finance, Wiley Blackwell, vol. 31(4), pages 1218-1239, October.
    8. Schroder, Mark & Skiadas, Costis, 1999. "Optimal Consumption and Portfolio Selection with Stochastic Differential Utility," Journal of Economic Theory, Elsevier, vol. 89(1), pages 68-126, November.
    9. Matoussi, Anis & Xing, Hao, 2018. "Convex duality for Epstein-Zin stochastic differential utility," LSE Research Online Documents on Economics 82519, London School of Economics and Political Science, LSE Library.
    10. Hao Xing, 2017. "Consumption–investment optimization with Epstein–Zin utility in incomplete markets," Finance and Stochastics, Springer, vol. 21(1), pages 227-262, January.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Epstein–Zin stochastic differential utility; Lifetime investment and consumption; Existence and uniqueness; Verification; Optional strong supermartingales;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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